Lyxor Weekly Brief: L/S Credit Resilience Defies Investors’ Concerns
Lyxor Weekly Brief: L/S Credit Resilience Defies Investors’ Concerns
Risk aversion continues to prevail so far in Q4 despite lower equity valuations and wider credit spreads. Expectations of a year-end rally in risk assets have faded, as concerns over Brexit remain acute and the probability of a recession in the U.S. keeps rising (although it stands at low levels). The growth divergence between the U.S. and Europe has further widened in Q4, pushing the U.S. Dollar index to record highs this year in a context where the ECB pointed to multiple headwinds at its latest monetary policy meeting.
Risk aversion continues to prevail so far in Q4 despite lower equity valuations and wider credit spreads. Expectations of a year-end rally in risk assets have faded, as concerns over Brexit remain acute and the probability of a recession in the U.S. keeps rising (although it stands at low levels). The growth divergence between the U.S. and Europe has further widened in Q4, pushing the U.S. Dollar index to record highs this year in a context where the ECB pointed to multiple headwinds at its latest monetary policy meeting.
Such market conditions continue to favour low beta hedge fund strategies. Since the beginning of December, Merger Arbitrage and L/S Equity Market Neutral outperformed, while L/S Equity remains under pressure. Relative Value arbitrage was resilient. Based on a peer group of 28 onshore L/S Credit strategies, the median performance was -0.3% month-to-date (up to December 12th) and -1.3% quarter-to-date. Yet, liquidity concerns have investors in L/S Credit strategies on defensive mode. According to Morningstar data, onshore Fixed Income strategies experienced large outflows in September and October.
Going forward, we note that U.S. corporate leverage has stabilized since 2015 at levels that prevailed in the run-up to the Global Financial Crisis. High yield default rates forecasted by rating agencies in twelve months remain nonetheless benign in Europe and the U.S. They are expected to remain below 2.5% against an average of 2.7% and 3.4% respectively over the past five years. Yet, liquidity tensions can flare up rapidly in current market conditions and cause wide fluctuations in asset prices. We are ourselves bearish on credit. We expect wider spreads across regions as a consequence of softer macro data, the end of QE in the euro area and asset reallocation out of credit in favour of Treasuries. Investors are thus probably right to be concerned. Yet, L/S Credit managers are themselves defensive in their positioning. Their resilience in Q4 is quite illustrative. In our view, the above supports a Neutral stance on L/S Credit strategies and a preference for strategies with lower market directionality.